A few weeks ago I had to do some thinking on how to go about choosing the right discount rate for discounting a series of cash flows. After doing some research, I found an excellent article published by the Acton Foundation for Entrepreneurial Excellence entitled Warren Buffett and His 9% Discount Rate. The article is not too long at five pages and it discusses several methods of choosing a discount rate before explaining the brilliance of sticking with a 9% discount rate regardless of how the risk free rate of return changes.
The first method discussed is the capital asset pricing model (CAPM) which uses the past instability of the prices of a publicly traded stock as a proxy for future risk. This was interesting, but ultimately unattractive for me as a value investor. High volatility or price instability does not necessarily mean a stock is riskier. I actually think such an assumption is quite dumb as high volatility can actually provide attractive entry points for a stock that make the purchase extremely low-risk.
Next is the venture capital method which does not really apply to me.
Finally, the article discusses the 9% discount rate and how it allows an investor to avoid speculative booms and take advantage of the inevitable speculative busts that follow. I highly recommend reading this article if you are an investor or if you ever are discounting future cash flows to determine if you should purchase or sell a business.
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